Deciding on a business structure for your business affects more than just how you’ll file taxes. Ramifications range from legal, administrative, and financial to your company’s name. Businesses with more than one owner typically structure their companies as limited liability companies (LLCs) or partnerships.
LLC vs. Partnership
That decision ultimately has vast consequences, so let’s break it down to see the proper structure for your business.
By default, businesses with more than one owner are considered partnerships in the states where the company is formed. Like a sole proprietorship, each partner owns an equal portion of the assets and liabilities of the business unless stipulated differently in the partnership agreement. Also, while no specific filing or registration procedures are required to start a partnership, partnerships must still comply with the permits, licenses, filing, and tax requirements expected of all businesses.
There are several types of partnerships depending on how the company is structured and where it’s based.
- General Partnership (GP). The general partnership is the most straightforward partnership structure—easy to form and easy to dissolve. Once the two (or more) partners create and sign the formal partnership agreement, the business is official. There is no required registration with the state. A general partnership divides ownership and profits equally unless different conditions are outlined in the partnership agreement. Likewise, all partners have equal power to make company decisions about contracts and financing. In addition, each partner retains equal liability and is held responsible for the company’s debts and legalities. Finally, general partnership owners are not employees of the company. Instead, they receive owner draws.
- Limited Partnership (LP). Unlike the general partnership, limited partnerships require registration with the state. They must follow state laws regarding information in a limited partnership agreement, reserving an LP company name, partner duties, and annual reporting obligations. Limited partnerships are for partners seeking investors but who don’t want to deal with the more complicated compliance issues involved with forming a corporation or LLC. The structure of limited partnerships involves at least one designated general partner and one or more limited partners. The limited partners invest money into the company but do not actively participate in the company’s daily operations. The general partner handles day-to-day operations. In addition, the limited partners share in the company’s profits but never the debts and liabilities and therefore never lose more than they’ve invested.
- Limited Liability Partnership (LLP). Not all states recognize limited liability partnerships, and some require the company to register as a Professional Limited Liability Partnership or PLLP. In essence, the limited liability partnership is a business structure used principally by professionals (e.g., attorneys, accountants, physicians, engineers, dentists, architects). Also, typically the state requires all partners to be licensed in the same profession. While the LLP does allow for equal responsibility of all partners, it limits the partners’ personal liabilities. Again, the amount of personal liability protection varies by state.
There is also a partnership referred to as a Limited Liability Limited Partnership (LLLP) in the real estate industry. In this structure, all partners have limited risk and work as an advantage for investor groups looking to build large hotels, commercial buildings, and apartment communities.
All in all, starting a partnership is relatively easy and features minimal paperwork and few regulations. Still, a partnership can also open the owners to unwanted risk and damaging personal liability. For those reasons, many co-owners choose to form a limited liability company.
Limited Liability Company (LLC)
The LLC is a formal business structure, a legal entity registered with the company’s home state and accountable for the rules and regulations afforded to LLCs within the state. Unlike a partnership, LLC owners are considered separate from the company and are not responsible for the company’s debts and liabilities. According to state doctrine, LLCs (when correctly formed and compliance is kept up to date) maintain their obligations regarding the business’s liabilities, protecting owners from lawsuits and debt concerns.
In an LLC, owners are called “members.” According to the IRS, most states do not restrict ownership so that members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members in an LLC, and most states allow a single owner to form an LLC. In fact, many sole owners form an LLC for the protection from personal liability it affords. When there is more than one owner/member, the LLC is referred to as a “multi-member LLC,” and all members enjoy the same liability protections.
Essentially, the LLC is a hybrid of a partnership and a corporation. Like a corporation, the primary advantage is, as the name implies, the limited liability of the owners/members. However, there is also a tax advantage, which we’ll discuss later.
Another advantage is the LLC’s management flexibility. An LLC can be member-managed or manager-managed, depending on the discretion of the company owners.
- Member-managed LLC: The owners/members manage the daily operations of the business.
- Manager-managed LLC: The owners/members designate one (or more) managers to oversee the company.
By default, most states consider LLCs to be member-managed unless the operating agreement specifies something other.
In most states, the requirements for an LLC are as follows:
- Choose and register a unique business name. The name should contain the term LLC.
- Fill out and file an “Articles of Organization” form with the Secretary of State. Every state has its document to fill out and file, so it may be called Certificate of Organization or Certificate of Formation.
- Another document not required but strongly recommended is the LLC Operating Agreement. Each owner should be involved with the wording and sign the operating agreement that outlines the company’s management structure, investor contributions, profit division, and contingencies, such as what happens to the LLC if a member leaves or dies.
- If you plan on expanding to different states, the LLC needs to appoint a “registered agent.” A registered agent acts as a point of contact for official paperwork for the company.
- Some states may also require new LLCs to file a “Statement of Information” along with the Articles of Organization. The Statement of Information asks for the company name, partner information, and business address.
Filing fees for LLCs vary by state, and if you have locations in other states, you’ll need to register the LLC in those states, also, and pay fees in each state. Although every state is different, most states require LLCs to file annual notices and pay a fee with the Secretary of State’s office verifying the LLC is still in business and update information about the company and its members. Many states also require LLCs to pay an annual Franchise Tax.
Tax Filing Differences
Besides the LLC’s registration requirements and the LLC’s liability protections, taxes can be reported differently in a partnership vs. an LLC.
In general, LLCs and partnerships are deemed “pass-through” entities for tax reporting purposes. The company’s profits and losses are passed down to the partners’/members’ personal tax returns. The company itself does not pay income tax, and all passed-on profits are subject to self-employment taxes (Medicare and Social Security) and income tax. Similarly, LLC members and GP partners are not considered employees and do not receive paychecks.
The partnership structure reports company income, deductions, gains, and losses on a Schedule K-1, IRS Form 1065 with the IRS. Then each partner uses the information from the IRS form to report their share of the partnership’s income/loss on each individual tax return.
Likewise, a multi-member LLC is taxed like a partnership by default using IRS Form 1065. However, unlike a partnership, the LLC structure has the option to be taxed as a Subchapter S Corp. The S Corp election allows the LLC members to be treated as employees, so only wages and salaries are subject to self-employment taxes. Then, remaining profits can be allocated as distributions and therefore not subject to Social Security and Medicare taxes. To elect S Corp status with the IRS, LLCs must file IRS Form 2553 by March 15 of the current tax year. If you miss the deadline, the S Corp election won’t go into effect until the following tax year.
Which is Best for Your Business?
Every business is different, and every business owner feels differently about how they want to manage and operate their company. The best advice is to ask yourself and your partners if the liability protections afforded by the LLC are worth the extra fees and paperwork required. Then talk to your accountant and attorney for advice before making a final decision.